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Know the risk you’re taking on

Mar 12 2020 09:02
Schalk Louw

As I was writing this, we were just entering the month of March, following a February filled with so much negativity that I’m sure we would all just like to forget it as soon as possible.   

They say that it is always the darkest before the dawn, and although this may not be the answer that investors are looking for, it is the best advice in terms of what not necessarily to do right now. 

Sometimes it is better to listen to that worried little voice in your head warning you not to follow the herd. 

Make no mistake, I’m not saying that the worst is over. What I’m suggesting is that you should look at the past and how history can help you to think twice before you sell everything because you’re panicking. 

A great tool to use in times of high volatility, is the volatility ratio (VR). 

Every time the volatility index (VIX) of the Chicago Board Options Exchange (CBOE) moved to levels of above 40, it was the greatest opportunity to buy in the market — ever. It stayed that way until it moved back to levels of around 10, which normally acts as an indicator that the market is starting to turn.

Before I continue, however, I would like to explain how investors can use volatility not only to determine risk, but also to point out possible investment opportunities and dangers.

Volatility is not a directional indicator, but rather a measure used to express changes in pricing as a percentage. 

If share A’s price rises from 100c to 101c, it indicates a positive change of 1%. If share B’s price moves from 200c to 198c, it is seen as a negative change of 1%. The VR of both shares is the same (1%), therefore the VR of share A is equal to that of share B. 

The VR can be used to determine the risk of a particular investment. When an investment in a share, for example, has a VR of 20, it means that the investment has already moved up or down by 20% during the period in question.

This means that if you do decide to buy this share, you don’t only have an opportunity to grow your investment by 20%, you also risk losing 20% of its value. 

The lower the VR, therefore, the lower the risk. Or so it seems. What this tells us, is that emotions play a massive role in the decision-making process during times of high volatility, and investors then have the tendency to force the market to levels well below its fair value. 

In times of low volatility, on the other hand, investors are so confident that the market will not drop to lower levels that they force it upwards.

The US stock market has always been considered as being in completely oversold territory when the VR reaches levels above 40, while it is considered as saturated when it moves closer to 10.

Until recently, we have seen the VIX trading at levels of around 10% on a regular basis and investors simply refused to believe that the S&P 500 Index could experience a decline. 

The coronavirus (Covid-19) outbreak, however, has brought this gravy train to an abrupt halt, and it’s not just causing world markets to crash, but also the US market. 

The S&P 500 has declined by 13%, in just the two weeks between 14 and 28 February 2020. And so, for the first time since September 2011, the VIX has closed above 40% at month-end (see graph). 

Schalk graph

Don’t get me wrong, I’m not calling the past month’s events nothing to worry about. Clearly the uncertainty factor is still extremely high in stock markets. But historical data is showing us that now is the time to remain cool, calm and collected. 

Since 1992, we have only seen the VIX close month-end at above 40% a total of eight times. These included, among others, a massive market collapse in 1998, the build-up to the war in Iraq at the end of 2002, and the Great Recession and market collapse of 2008.

In each of the eight instances where the VIX measured above 40%, it was backed by good reasons. However, were any of these reasons good enough to sell your shares? Most definitely not. 

The S&P 500 delivered the following average returns over the following periods after each of the eight occurrences: six-month returns of 20.5%, one-year returns of 30.9%, and two-year returns of 50.6%.

As mentioned before, investors shouldn’t use the VR as a directional indicator, but rather to determine risk and a possible overreaction to market events.

It doesn’t matter how you use the stock market to invest as long as you make sure that you have done your homework properly and that if you decide to follow the herd, you don’t bite off more risk than you can chew. 

Schalk Louw is a portfolio manager at PSG Wealth.

This article originally appeared in the 19 March edition of finweek. Buy and download the magazine here or subscribe to our newsletter here.

investment  |  portfolio  |  risk
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